The BoC's Dilemma: Should Canada Cut Rates Further Amid Trade War Fallout?

The Bank of Canada faces a high-stakes balancing act in 2025. With trade tensions with the United States persisting and global economic uncertainty looming, the central bank must decide whether to further cut interest rates to cushion the Canadian economy—or hold firm to avoid exacerbating inflationary pressures. This dilemma is compounded by starkly divergent performances across sectors, where manufacturing and trade-exposed industries struggle under U.S. tariffs, while services and domestic demand show surprising resilience.

A Fragile Economic Landscape

According to a report by Reuters, the Bank of Canada maintained its key interest rate at 2.75% as of July 30, 2025, citing resilience in the broader economy despite trade-related risks [1]. Governor Tiff Macklem acknowledged that recent trade agreements with Japan and the European Union have reduced the likelihood of a full-scale global trade war, but the U.S. remains a wildcard. Tariffs on Canadian steel, aluminum, and automobiles have already disrupted supply chains and raised input costs for manufacturers, leading to a 1.5% contraction in the sector in June 2025 [2]. Meanwhile, the services sector—driven by domestic consumption and population growth—has absorbed some of the shock, with business and consumer confidence showing modest improvement [3].

The Bank of Canada’s April 2025 Monetary Policy Report underscored this duality, modeling scenarios ranging from trade de-escalation (supporting recovery) to full-scale conflict (triggering recession and inflation) [2]. Current data suggests the economy is teetering between these extremes, with vulnerabilities concentrated in sectors reliant on cross-border trade.

Sectoral Resilience and Vulnerabilities

The manufacturing sector, particularly in Ontario and Quebec, has borne the brunt of U.S. tariffs. Data from the Canadian Federation of Independent Business (CFIB) indicates that 70% of manufacturing firms reported increased costs due to trade barriers, with many passing these expenses to consumers—a second-round effect that risks stoking inflation [4]. In contrast, the services sector—encompassing healthcare, education, and professional services—has thrived on stable domestic demand. According to Canada’s State of Trade 2025, services accounted for 75% of GDP growth in Q2 2025, offsetting some of the drag from goods-producing industries [5].

Small and medium enterprises (SMEs) present a mixed picture. While immigrant-led SMEs have leveraged Canada’s free trade agreements to expand into new markets, the broader SME community faces indirect trade war impacts. A report by the Department of Foreign Affairs, Trade, and Development notes that SMEs—despite contributing 40% of export value—struggle with supply chain disruptions and rising compliance costs [6]. Government interventions, such as the $5 billion Strategic Response Fund and the “Buy Canadian” procurement policy, aim to mitigate these challenges, but their efficacy remains untested in a prolonged trade conflict.

Strategic Rate Cuts: A Double-Edged Sword

The Bank of Canada’s decision to hold rates steady in July 2025 reflects its cautious approach to balancing growth and inflation. Lower rates could reduce debt servicing costs for households and businesses, particularly in vulnerable sectors. For example, the Financial Stability Report—2025 highlights that easing monetary policy has already bolstered capital buffers for Canadian banks, enabling them to absorb potential credit defaults from trade-exposed industries [1]. However, aggressive rate cuts risk inflating asset prices and consumer spending, which could clash with the Bank’s mandate to maintain price stability.

Market expectations suggest the BoC may act soon. As of September 2025, market-based odds of a rate cut surged to 90% following a weak employment report that showed unemployment rising to 7.1% in manufacturing [7]. Yet, analysts are divided. Some argue that further cuts are necessary to prevent a recession, while others warn that monetary policy alone cannot offset the structural damage caused by tariffs. RBC’s economic outlook emphasizes that Canada’s industrial strategy—focusing on energy and critical minerals—offers long-term resilience but cannot shield the economy from immediate trade shocks [8].

The Path Forward

The BoC’s next move hinges on two critical factors: the trajectory of trade negotiations and the resilience of domestic demand. If U.S. tariffs de-escalate, rate cuts could catalyze a recovery in manufacturing and SMEs. Conversely, if tensions escalate, the Bank may need to prioritize inflation control over growth support.

For investors, the key takeaway is sectoral diversification. While manufacturing and energy sectors remain exposed to trade risks, services and technology-driven SMEs offer relative safety. The BoC’s strategic timing of rate cuts—whether in September or later—will likely determine the pace of recovery in vulnerable industries.

Source:
[1] Bank of Canada holds rates steady and says global trade war risk has eased [https://www.reuters.com/world/americas/bank-canada-holds-rates-steady-says-global-trade-war-risk-has-eased-2025-07-30/]
[2] Financial Stability Report—2025 [https://www.bankofcanada.ca/2025/05/financial-stability-report-2025/]
[3] Bank of Canada holds interest rate at 2.75% as economy [https://www.cbc.ca/news/business/boc-july-decision-1.7597146]
[4] Impact of tariffs on Canadian businesses [https://www.doanegrantthornton.ca/insights/how-new-tariffs-could-affect-canadian-businesses/]
[5] Canada's State of Trade 2025: Small and medium enterprises [https://international.canada.ca/en/global-affairs/corporate/reports/chief-economist/state-trade/2025]
[6] Canada-U.S. Trade War [https://www.cfib-fcei.ca/en/site/us-tariffs]
[7] 'Exceptionally weak' jobs report prompts markets [https://www.theglobeandmail.com/investing/markets/inside-the-market/article-market-based-odds-of-boc-rate-cut-this-month-zoom-to-90-after-weak/]
[8] Canada's economic outlook: Shifting tides as tariff threats de-escalate [https://www.rbc.com/en/thought-leadership/economics/economy-and-markets/macroeconomic-outlook/canadas-economic-outlook-shifting-tides-as-tariff-threats-de-escalate/]